How the Fed Could Benefit from Lower Mortgage Rates
The Fed has played a major role in consumer mortgage rates over the past decade and change.
Back in 2008, they began purchasing hundreds of billions in mortgage-backed securities (MBS). This was known as quantitative easing, or QE for short.
The goal was to drive interest rates lower and increase the money supply. Doing so would boost economic activity, aka lending, and help us out of the Great Recession.
But there were consequences to such a plan – namely something called inflation.
The Fed also knew it couldn’t hold onto these assets forever, but how would they unload without riling the markets?
Quantitative Easing Led to Raging Inflation
The Fed conducted four rounds of quantitative easing, which involved buying both MBS and U.S. treasuries.
The final round of QE extended all the way into 2020 as the COVID-19 pandemic dislocated the world economy.
In the process, mortgage rates hit all-time record lows. The 30-year fixed dipped as low as 2.65% during the week ending January 7th, 2021, per Freddie Mac.
And the 15-year fixed fell to 2.10% on July 29th, 2021. These low rates were unprecedented.
They were so cheap that they set off a housing market frenzy, with home prices rising nearly 50% from late 2019 to mid-2022.
Clearly this was unhealthy growth, and a symptom of easy money.
Fed Finally Takes Action to Cool the Housing Market
The Fed realized that they had an inflation problem. They also realized housing demand had gotten completely out of control.
Folks were buying homes for any price, thanks in huge part to the record low mortgage rates on offer.
It wasn’t just a housing supply issue, as some had pointed out. This meant they had the power to cool off the overheated housing market, simply by reversing course.
Once they finally took notice, quantitative tightening (QT) was implemented in mid-2022. It works the exact opposite way of QE.
Instead of buying, they’re letting these securities run off. And this means unloading treasuries and MBS, albeit at a reasonable rate with caps in place.
Without a big buyer of MBS, supply increases, bond prices drop, yields rise, and consumer mortgage rates go up.
No one could have guessed how much they’d rise in such a short period. That too was unprecedented.
Mortgage rates essentially doubled in a year, the first time that has happened on record.
The 30-year fixed ended 2022 at 6.42%, up from about 3.11% a year earlier, per Freddie Mac. Mission accomplished.
Home Prices Peak and Begin to Fall
Once the reality of much higher mortgage rates set in, the housing market stalled and began to fall.
It began with decelerating year-over-year gains, which were in the double-digits. And eventually led to month-over-month declines.
The latest report from CoreLogic shows home prices increased 8.6% in November 2022 compared with November 2021.
But on a month-over-month basis, were down 0.2% in November 2022 compared with October 2022.
They’re currently still expected to rise 2.8% from November 2022 to November 2023.
However, individual markets have seen much bigger declines, especially if you consider peak prices that might not be captured in the data.
Zillow recently pointed out that home values were actually lower than last December in Austin (-4.2%), San Francisco (-2.0%), and Seattle (-0.6%).
This has caused a lot of people to ring the alarm bells, calling for another housing market crash.
Low Mortgage Rates to the Rescue?
While much higher mortgage rates made 2022 an awful year for home buyers, real estate agents, and mortgage industry workers, 2023 might be better.
Sure, it seemed as if we were on the precipice of a crash, but it was mostly driven by substantially higher mortgage rates.
At their worst, 30-year mortgage rates climbed above 7% in late 2022, but there’s been some serious relief since.
The 30-year fixed is back around 6%, and if you’re willing to pay discount points, rates in the low-5% range aren’t out of the question.
Aside from this being psychologically better, lower rates boost affordability and allow home sellers to fetch higher asking prices.
This means the spring home buying/selling season might actually be decent. It also means forecasts for home prices to rise year-over-year could hold up.
Of course, holding up is a lot different than years of double-digit gains.
But it does represent a healthier housing market, which we should all be happy about.
Inflation May Have Peaked
If you look at the last few CPI reports, it appears inflation may have peaked. We’re not out of the woods, but there are positive signs.
At the same time, the Fed may also be done raising its own target fed funds rate. The prime rate is dictated by the fed funds rate.
This has increased HELOC rates for scores of homeowners. If/when the Fed stops raising and begins lowering their own rate, HELOC rates can come down.
That will spell more relief for existing homeowners with these lines of credit.
Perhaps more importantly, if inflation truly has peaked and is falling, long-term mortgage rates can come down too.
Lower mortgage rates will buffer the housing market and limit any downward movement on home prices.
These lower mortgage rates may even benefit the Fed!
Okay, How Do Lower Mortgage Rates Benefit the Fed?
I may have buried the lede, but we got here eventually.
Remember, the Fed has a ton of MBS on its balance sheet. At last glance, around $2.6 trillion.
They’re currently letting up to $35 billion in MBS mature and “run off” each month.
Since QT began in June 2022, its MBS holdings have fallen by roughly $67 billion, or about 2.5%. That’s apparently too slow.
Here’s the problem the Fed is facing. With current mortgage rates significantly higher than the rates on all those MBS, no one is refinancing their mortgage or selling their home.
So most of these MBS aren’t getting paid off. This may force the Fed to outright sell the MBS, which would likely be bad for rates.
But if mortgage rates drop back to more reasonable levels, we might see an uptick in home sales, mortgage refinancing, and so on. If that happens, the associated MBS get paid off.
This would allow the Fed to unload their trillions in MBS a lot faster. And that could benefit the Fed without upsetting the markets.
So in a sense, the Fed could begin to root for lower mortgage rates. Not 2-3% rates, but rates in the 4-5% range.
Also, a recent Fed working paper found that an expansionary monetary policy allows low-wealth households “to get their foot in the door” and build wealth via homeownership.
Meanwhile, tighter policy “appears to prevent many lower-income families from buying homes.”
Read more: 2023 Mortgage Rate Predictions